Tuesday, 23 December 2014

Last week the
European Central Bank published the letter it sent on August 5, 2011 to the
then Prime Minister of Spain, Mr Zapatero. That was at a time of intense crisis
in the Eurozone. Many thought that the Eurozone would implode.

The ECB’s
letter to the Spanish government is not the only one the ECB sent to Member
States' governments. A similar letter was sent to the Italian Government. The
letter is of great significance because it reflects the ambition of the central
bank to determine macroeconomic policies in the Eurozone. This ambition should
be checked, for two reasons.

First, the
letter illustrates the intensity of the micro-economic
management the ECB intends to apply in crisis countries. The letter contains a
detailed list of what according to the ECB needs to be done in the labor
market. Thus, collective agreements should be abolished and should be organized
at the level of the individual firms. In addition, these agreements should not
contain indexation clauses, even when these are entered into freely. Two things
stand out here. First, there is the detail of the measures that the ECB would like
to impose. In doing so, it substitutes itself to national governments in the
formulation of national economic policies.

Second, it is
striking to find that these policy prescriptions are based on an economic
theory for which there is actually no serious empirical evidence. On the
contrary, there is a strong empirical research suggesting that the degree of
decentralization of wage bargaining should not go too far. The consensus among
economists is that wage bargaining at the level of individual companies harms the
economy, because it can easily give rise to a wage-price spiral when an
external shock such as an oil price increase occurs. Yet extreme decentralisation
of wage bargaining is what the ECB wants to impose in member-countries of the
Eurozone. The policy that the ECB seeks to impose is not based on evidence but
on ideology.

The second
reason why the ECB’s ambitions in setting the policy agenda in the Eurozone
must be checked has to do with governance. The ECB is a public institution,
which has been given a strong status of political independence. The latter
implies that politicians should abstain from interfering in monetary policy.
They should certainly not give instructions to the central bank on how to
conduct monetary policy. The reverse, however, is equally true. The political
independence of the ECB can only be safeguarded if that institution keeps itself
aloof from the political process and abstains from giving instructions to
governments about how economic policies should be conducted. The ECB sins
against this principle. In doing so, she puts her own independence at stake.

The ECB has
set itself the target of keeping inflation close to 2%. It is failing
spectacularly in reaching that objective and as a result, creates a risk of
deflation that today increases the debt burden of national governments. An
institution that fails to achieve its own objectives cannot afford to impose
its ideas on national governments, lest these governments will turn themselves
against the ECB.

The
instructions the ECB gives in its letter to the Spanish government lead to an
even more fundamental governance problem. The ECB consists of civil servants
who bear no political cost of the decisions they try to impose on national
governments. The latter bear the full political costs of these decisions. They
risk to be thrown out of office when they implement policies forced upon them
by the ECB. The civil servants of the ECB go home unharmed. This is a
governance structure that is unsustainable and that will be rejected. It is
important that the ECB realises this and reduces its ambition to rule the
politicians. Failure to do so will greatly harm the ECB.

Wednesday, 29 October 2014

The European Central Bank is becoming the singe supervisor of
the large and medium-sized banks in the Eurozone. Before taking on this
responsibility it was important for the ECB to be well informed about the
health of the Eurozone banks. This health report was released last Sunday.

What is most striking is that relatively few banks failed the
test, i.e only 14 out of 130. That is
quite a success. Was the exam too easy? At first sight this does not seem to be
the case. The ECB examined, for example, what the effect would be of a decrease
of GDP by 5% spread over two years on the value of the banks’ assets. That is
quite a steep recession, comparable to the one that hit the Eurozone in 2008-09.
Of course, the ECB could have investigated more pessimistic scenarios. For
example, it could have asked what would happen if a new crisis erupted in the
government bond markets? The ECB investigated only mild increases (2 to 3
percent) in the government bond yields. During the period 2010-11, these
increases were much larger, reaching 10 percent or more. Should the ECB not
have been tougher and simulated more intensely negative economic shocks?

This is like asking how pessimistic a central bank should be?
There are negative scenarios that are so unfavorable that not even half of the
banks would survive these. A new debt crisis like the one we experienced in
2010-11 is such a scenario. Such a negative scenario is not even very unlikely.
But should a central work out the consequences of a disaster?

The ECB walks on a tightrope. An overly pessimistic scenario
that would lead to the conclusion that more than half of the banks are at risk would
be the equivalent of a terrorist suicide attack. The publication of such a scenario by the
central bank would lead to an immediate banking crisis. A central bank that
cares about financial stability should not place a bomb in the market place. The
ECB has not done so.

Yet the ECB did not fall into the other extreme. It did not
let all the banks pass the test. Fourteen
banks failed. This is not a high number. But neither is it a ridiculously low
number that would have harmed the reputation of the central bank. The ECB
carefully considered how far it could go in balancing the need to maintain
financial stability with the desire to keep its reputation intact. The ECB
seems to have succeeded in this balancing act.

Should we expect that the bank stress-test now is the
beginning of a new era and that banks will be willing to expand bank credit, as
the Vice-President of the ECB, Vítor Constâncio, suggested? This is highly
unlikely. The depressed nature of bank credit today has much to do with the
fact that economic activity in the Eurozone has slowed down again. As a result,
the demand for credit by firms and consumers remains low. In order to overcome
this, it will be necessary to stimulate aggregate demand. The best way to do
this is by increasing public investment.
Put differently, the stress-test was necessary to create the conditions
for banks to start lending again. But such an increase will only be possible if
the Eurozone ends the period of austerity and starts stimulating investment
again. Unfortunately, the resistance
towards fiscal stimulus is the highest in those countries that face the least
financial constraints to engage in such policies.

Tuesday, 30 September 2014

The Russian military invasion of Ukraine has paid off. The
Crimea is now part of Russia. Some Eastern regions of Ukraine also risk
becoming incorporated into Russia in the near future. Where will this end?

Putin knows that the West is not willing to send soldiers to
Ukraine to defend the sovereignty of that country. This gives him a strategic
advantage over the West. In addition, it gives him an incentive to continue his
aggressive and expansionary policies. We
should therefore not be surprised that new aggressive moves will be initiated
elsewhere (in the Baltic countries for example where large Russian minorities
live).

Up to now the West has reacted in a feeble way. Financial
assets of important Russian individuals have been blocked. Russian companies
are prevented from borrowing in financial markets or from transferring assets.
These things hurt but insufficiently so. Putin will not be stopped by the
West’s half-baked sanctions that have little impact on the Russians economy.

In order to stop aggression a policy must be implemented that
will really hurt the Russian economy. This policy can only work if it hurts the
Russian revenues from exporting oil and gas. How can this be done without
hurting the West?

Today, imports of Russian crude oil account for 34% of total
EU imports of crude oil. For gas this percentage is 32%. So we are very
dependent on Russia for our energy imports. What about the Russian dependence
on us?

The export of crude oil from Russia to the EU now accounts for
84% of total Russian oil exports; the percentage for gas is 80%. Those exports
are of great importance for Russia and for the Russian budget. In fact the
sales of Russian oil and gas to the EU provide for more than half of all
Russian government revenue. Thus it can be said that Russia is more dependent
on its exports to the EU than the EU is dependent on Russian oil and gas
imports. That creates an opportunity to put pressure on Russia in order to
increase the economic cost of aggression.

Here's what I would do if I were European policymaker. I would
impose a tax on oil and gas from Russia. Such a tax would have the following
effects. First, EU importers would have to pay more for Russian oil and gas and
would therefore look for alternative sources of supply. This would reduce the
demand for Russian oil and gas. Since the EU is a very big player this effect
would be big also. Second, and this follows immediately from the first effect,
Russia would have to lower the price of its oil and gas so as to find other
buyers in the world. This would create an important shortfall in Russian
government revenues, reducing the capacity of Russia to wage wars.

One may object here that this tax would also hurt us because
it would raise the price the EU consumers would have to pay for oil and gas. This
is not the case, however. The import tax generates revenues for the
EU-governments. These revenues could be used to compensate the EU-consumers.
Alternatively, they could be used to promote policies aiming at making us less
dependent on fossil fuel. Whatever we chose to do with the tax revenue, we
would not be harmed by it.

This is an application of what economists call an “optimal
tariff”. By the very fact that we are more important for Russia than the other
way around, we can exploit our strong economic power and impose an import tax
that maximizes our welfare and reduces Russia’s. We should do just that.

Some will argue that Russia could retaliate by stopping the
export of oil and gas to the EU. My contention is that Russia would not do
this. Such a retaliation would lead a decline of government revenues of more
than 50% leading to a paralysis of the Russian government. It would hurt Russia
much more than it would hurt the EU.

The European Union has the economic power to confront and to
stop Russian aggression. It must use this power.

Tuesday, 16 September 2014

Slow growth in the Eurozone has become endemic since the start
of the sovereign debt crisis in 2010. This is made very clear in Figure 1, which
contrasts the growth experience of the Eurozone with the non-Eurozone EU-member
countries since the start of the financial crisis in 2007. What is striking is that up to the Eurozone
sovereign debt crisis of 2010 the growth experiences of the Eurozone and
non-Eurozone countries in the EU were very similar. Both groups of countries
saw their boom collapse and turn into a deep recession in 2008-09. Both
recovered relatively quickly in 2010. Since 2011, however, the two groups of
countries depart. The Eurozone experiences a new recession and since then has
experienced a growth rate that on average has been 2% below the growth rate of
the EU-countries that are not part of the Eurozone.

Source: Eurostat

What happened since the start of the sovereign debt crisis
that has led to a systematic decline of
economic growth in the Eurozone as compared to the non-Euro EU-members?

In Brussels, Frankfurt and Berlin it is popular to say that
this low growth performance of the Eurozone is due to structural rigidities. In
other words, the low growth of the Eurozone is a supply side problem. Make the
supply more flexible (e.g. lower minimum wages, less unemployment benefits,
easier firing of workers) and growth will accelerate.

This diagnosis of the Eurozone growth problem does not make
sense. As is made clear from Figure 1 the Eurozone countries recovered as
quickly from the recession of 2008-09 as the non-euro countries. If the problem
was a structural one, it also existed in 2008-09. Yet these structural rigidities
did not prevent the Eurozone countries from recovering quickly in 2010. Why
then did structural rigidities from 2011 on suddenly pop-up to produce lower
growth in the Eurozone than in non-euro EU-countries, while they did not play a
role in 2010? Although this supply-side
story does not hold water, it continues to provide the intellectual underpinnings
of the Eurozone policymakers who continue to insist on structural reforms.

There is a better explanation for the Eurozone growth puzzle.
This is that demand management in the Eurozone was dramatically wrong since the
start of the sovereign debt crisis. The latter led the Eurozone policymakers to
impose severe austerity on the peripheral Eurozone countries and budgetary
restrictions on all the others. This approach was based on a failure to
recognize that the Eurozone was still in the grips of a deleveraging dynamics.
After the debt explosions in the private sector during the boom years, private
agents were still deleveraging. As a result of austerity, both the private and
the public sector tried to deleverage at the same time. This introduced a
deflationary bias in the Eurozone that led to a new recession during 2012-13,
the second one since the start of the financial crisis in 2007-8.

One of the most spectacular manifestations of the ill-advised
austerity programs was the strong decline in public investment in the Eurozone.
This is shown in Figure 2. It shows that after the sovereign debt crisis the
Eurozone governments, in the name of austerity, decided to dramatically reduce
public investment. How they could hope that this would promote economic growth
will remain a mystery. In fact, such a
decline in public investment is sure to lead to lower production possibilities
in the future, i.e. to less supply in the future.

All this leads to the question of what to do today?
Governments of the Eurozone, in particular in the Northern member countries now
face historically low long-term interest rates. The German government, for
example, can borrow at less than 1% at a maturity of 10 years. These
historically low interest rates create a window of opportunities for these
governments to start a major investment program. Money can be borrowed almost
for free while in all these countries there are great needs to invest in the
energy sector, the public transportation systems and the environment.

This is therefore the time to reverse the ill-advised
decisions made since 2010 to reduce public investments. This can be done at
very little cost. The country that should lead this public investment program
is Germany. Public investments as a percent of GDP in Germany are among the
lowest of all Eurozone countries. In 2013 public investment in German amounted
to a bare 1.6% of GDP versus 2.3% in the
rest of the Eurozone.

Source: Eurostat

Such a public investment program would do two things. It would
stimulate aggregate demand in the short run and help to pull the Eurozone out
of its lethargic state. In the long run it would help to lift the long-term
growth potential in the Eurozone.

The prevailing view in many countries is that governments
should not increase their debt levels lest they put a burden on future
generations. The truth is that future generations inherit not only the
liabilities but also the assets that have been created by the government. Future
generations will not understand why these governments did not invest in
productive assets that improve their welfare, while these governments could do
so at historically low financing costs.

Thursday, 11 September 2014

The desire of a nation to be independent is eminently
respectable. If the Scots decide in a referendum to make the step towards
independence, there is very little an outsider like me can object to. What is
surprising to me is that the proponents of the Yes vote attach to their desire
for independence a desire to keep the pound as the currency for their future
nation. Surely, as anybody who has studied the functioning of monetary unions
will tell, the maintenance of the pound will severely limit the independence of
the new Scottish nation.

Why is this? When the future Scottish government will issue
bonds (as all governments of independent nations do) it will do this in pound
sterling. But this will be a currency over which the Scottish government will have
no control. For all practical purposes the pound will be like a foreign
currency from the point of view of the Scottish government.

The implication is far-reaching. It means that the Scottish
government will not be able to give an ironclad guarantee to its bondholders
that the cash (pounds) will always be there to pay them out at maturity. As a result, when the Scottish economy
experiences bad times and the Scottish government budget deteriorates, the
fragility of this arrangement will become manifest. Distrust and even fear may
be set in motion in financial markets leading to large-scale sales of Scottish
government bonds precipitating a liquidity crisis.

Is this a far-fetched scenario? This is exactly what happened
in countries like Ireland, Portugal, Spain, Greece; all countries, member of
the Eurozone, that have given up their monetary sovereignty and have taken over
a currency over which they have no control.

The core of the problem of these countries and of the future Scotland
is the absence of a lender of last resort in the government bond market. The Scottish
government will not be backed by a central bank that can be forced to provide
unlimited amount of liquidity support in times of crisis. Therefore it will not
be able to give a guarantee to bondholders that the cash will always be there
to pay them out at maturity.

The British government enjoys such a backstop. It can and it
will force the Bank of England to provide the support in times of crisis. The
Scottish government will lack this power. As a result its power as a sovereign
nation will be limited. It is surprising that the proponents of Scottish
independence are so much insisting on creating a nation with limited
independence.

How limited this independence will be can be gauged from what
happened to “independent” nations of the Eurozone. We have seen that when these
countries where hit by deep recessions and resulting budgetary deficits, the
liquidity support that was provided by the other member-countries was highly
conditional. The “Troika” (i.e. a group of foreigners) travelled to the
countries in question (Ireland, Portugal, Greece) and dictated the terms under
which liquidity support would be given. These terms were so intrusive that it
is no exaggeration to say that these countries lost much of their sovereignty
in the process.

If Scotland becomes independent and keeps the pound it could
negotiate the terms under which it will obtain the support of the Bank of
England in times of crisis. But these terms will necessarily involve budgetary
rules dictated by Westminster, pretty much like the member-countries of the
Eurozone have to accept these budgetary rules set in Brussels.

Why the proponents of Scottish independence want
to subject themselves to Westminster rule is a mystery to me. True independence
for Scotland can only be reached if that country creates its own money. In the
absence of monetary independence, Scotland will remain the slave of somebody else.
Westminster if it choses the pound; Brussels and Frankfurt if it choses the
euro.